Question

Discuss the pros and cons of these methods of financial statement analysis: ratio analysis, vertical analysis, and horizontal analysis. What do they tell us? Why do we need so many different methods?

Answer 1

Ratio Analysis

Ratio analysis is used to verify the plausible relationship between financila items in financial statements.

Pros:-

1.Easy to compare between two entities in same industry.

2.Useful for auditors to verify their work.

3.Helps to understand the trend of a business.

Cons:-

1.Comparing cannot be 100% possible with same ratios, this is because each business eventhough in same industry have different conditions.

2.Each company may follow different accounting for same model of business, thus ratios may become not comparable.

3.Ratios are historical ratios, and can be derived only when financial statements are released.

Vertical Analysis

Vertical analysis is used to determine the percentage of each item to the base amount of financial statements.

Pros:-

1.Helps to identify the significant items that form the base total

2.Helps to identify the reasons for material changes.

3.Helps in comparing two businesses and its percentage investment in each item.

Cons:-

1.The analysis is not standardised and thus can become very difficult to compare business in two different areas.

2.If the accounting of business lack cosistency, the conclusion can be misleading

3. Donot compare with previous period, so hard to understand the trend of business.

Horizontal Analysis

Horizontal analysis helps in understanding the percentage difference from previous year items.

Pros:-

1.Helps to understand the trend of a business.

2.More useful for investors on performance of business, when any new line of investment is made in previous years.

3.Helps to identify the reasons for significant changes from previous year.

Cons:-

1.Can not compare with previous year if there are significant changes in markets.

2.Do not identify the main items that form the base amount.

3.Not suitable for short term decision making.

Why do we need so many different methods?

As explained above each methods are suitable for specific situations and decision making. An analysis used by the management will not be preferred by investors and vice versa. So selection of each analysis depends on the objective of the analyzer. Thus there are multiple methods available.